Collateral

This is common across all areas of finance, not only the crypto space. For example, mortgages use your house as collateral, as the bank can repossess the property to recoup its losses if you fail to repay. An even simpler example is a pawn shop, which accepts personal goods such as jewelry as security for short-term loans, with the option to sell the goods to cover the cost of the loan.

In the context of crypto, collateral is essential for DeFi lending markets, which operate without credit checks, loan officers or traditional legal enforcement mechanisms. The process of posting and liquidating collateral is instead automated through smart contracts. Borrowers deposit assets such as BTC or ETH into a smart contract, receiving another asset in return, often a stablecoin like USDT.

Typically, crypto loan platforms require borrowers to deposit more value than they borrow — a system called overcollateralization. For example, on a loan platform such as Aave, a user might deposit $150 of ETH to borrow $100 of stablecoins. This $50 difference in value provides a buffer that protects the lender against sudden price volatility. This is important, since without identity checks or court enforcement, a DeFi protocol has no way to chase down a lender who fails to repay a loan.

Each DeFi loan has a set liquidation threshold: if the value of the collateral relative to the loan drops to a certain point, meaning the size of the buffer dwindles, it automatically sells those assets to recoup the cost of the loan. This event is called a liquidation. Avoiding liquidations requires monitoring open positions to ensure the price buffer remains sufficient.

This automated, overcollateralized system is why DeFi loans can be issued to anyone, anywhere, with no credit check. The identity and credibility of the borrower is essentially irrelevant when the terms of the loan are enforced in code.